There are different diagrams that you can use to explain Oligopoly markets.
It is important to bear in mind, there are different possible ways that firms in Oligopoly can behave.
Kinked Demand Curve Diagram
The firm maximises profits at Q1, P1 where MR=MC. Thus a change in MC, may not change the market price.
The kinked demand curve makes certain assumptions
- Firms are profit maximisers.
- If one firm increases the price, other firms won’t follow suit. Therefore, for a price increase, demand is price elastic.
- If one firm cuts price, other firms will follow suit because they don’t want to lose market share. Therefore, for a price cut, demand is price inelastic.
- This is how we get the ‘kinked demand curve
However, the kinked demand curve has limitations
- It doesn’t explain how the price was arrived at in the first place.
- Firms may engage in price competition.
If firms in oligopoly collude and form a cartel, then they will try and fix the price at the level which maximises profits for the industry. They will then set quotas to keep output at the profit maximising level.
The price and output in oligopoly will reflect the price and output of a monopoly. The Quantity Qm will be split between the firms in the cartel.
Economies of scale for Oligopolies
Oligopolies may benefit from economies of scale. This enables lower average costs with increased output. FIrms in oligopoly producing at Q1 achieve lower prices of AC1.
Efficiency of firms in oligopoly
- Larger firms can benefit from economies of scale – lower average costs – which might outweigh other inefficiencies.
- Allocative efficiency? Not clear but firms operating under kinked demand curve may end up setting price higher than marginal cost. Also firms able to successfully collude will set prices higher than MC. If oliogopolies are competitive then prices will be lower and more allocative efficient.
- Dynamic efficiency? Firms in oligopoly have profits they can use for investment in new products. Also, competitive pressures encourage them to innovate.